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Do Lower Interest Rates Revive Consumption? Not Always

Feb 11, 2016


The Reserve Bank of India governor Raghuram Rajan presented the sixth monetary policy statement for this financial year, earlier this month. In the policy he decided to maintain the status quo and not change the repo rate. Repo rate is the rate at which RBI lends to banks, which acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

After the policy, the representatives of the industry protested and said that they were expecting a repo rate cut, which would revive consumption as well as investments. As Chandrajit Banerjee, director of business lobby CII, said: "A rate cut would have been spot-on for rejuvenating the investment cycle. We hope RBI would resume the rate-cutting cycle in the subsequent monetary policy soon after the Union Budget to complement the government's efforts to revive private investments and bring the economy back to sustained growth."

Getamber Anand, president of real estate lobby CREDAI, echoed Banerjee's sentiments, when he said: "We are very disappointed. We were expecting a 25 basis points reduction in the repo rate." He also said that home loan interest rates should be lower than 9%.

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The belief is that at lower interest rates people borrow and spend more, and industries also invest more. This sounds very convincing but is essentially very simplistic thinking that lobbyists try to peddle.

Conventional thinking assumes a negative relationship between consumption and interest rates. But that is also a function of how people save money. Michael Pettis in his book The Great Rebalancing-Trade, Conflict, And the Perilous Road Ahead for the World Economy makes a very interesting point about China.

As he writes: "Most Chinese savings, at least until recently, have been in the form of bank deposits. In a financial system in which deposit rates are set by the central bank, the value of bank deposits is positively, not negatively, correlated with the deposit rate. Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption."

Given that a large portion of the financial savings are invested in bank deposits, any rise in interest rates should make people feel richer and in the process make them consume more.

Vice versa, any fall in interest rates should make people feel poorer and lead to lower consumption. Further, if the interest rate on deposits is lower than the rate of inflation, or around the rate of inflation, or not substantially different from the rate of inflation, any rise in interest rates should lead to a higher consumption.

As Pettis writes: "If deposit rates do not reflect market conditions-most important, inflation rates...then bank deposits, who measure their wealth in terms of the expected real return on their depositors, should welcome rising rates and deplore declining rates. The former should make them feel richer and so increase their consumption and the latter make them feel poorer."

This is something that is largely applicable to India as well. While the central bank does not set interest rates on fixed deposits as such, large portions of household financial savings are invested in bank deposits, provident and pension fund schemes (with a significant portion of these schemes being run by the post office). In these investments, as interest rates go up, people feel richer.

In 2012-2013, the 54.4% of household financial savings were in bank deposits and provident and pension fund schemes. Nearly 16.2% of household financial savings were held in the form of cash. Only 6.62% of household financial savings were invested in stocks and debentures. 24.4% of the savings were invested in life insurance, where it is next to impossible to figure out what returns to expect.

In 2011-2012, 56.7% of the household financial savings were invested in bank deposits and provident and pension fund schemes. In 2010-2011, 51% of the savings were invested in deposits and provident and pension fund schemes.

The point being that a major portion of household financial savings get invested in bank deposits and pension and provident fund schemes. This means when interest rates go up or are high, people are more likely to spend more.

Also, the another point that people forget is the multiplicity of needs. Not everyone is looking to borrow and spend when interest rates fall. As Malhar Nabar writes in an IMF Working Paper titled Targets, Interest Rates, and Household Saving in Urban China: "China's households save to meet a multiplicity of needs - retirement consumption, purchase of durables, self-insurance against income volatility and health shocks - and act as though they have a target level of saving in mind. An increase in financial rates of return, which raises the return on saving, makes it easier for them to meet their target saving."

This is a point that needs to be taken into account. It applies as much to India as it does to China. People are trying to save money for emergencies as well their retirement, education and weddings of their children and so on. And this lot gets hurt every time the interest rate on their deposits goes down.

This means they need to save more and consume less when interest rates go down. Hence, lower interest rates do not lead to an increase in consumption for everybody. The truth is a lot more nuanced than that.

There is another point that needs to be made here. Between December 2014 and December 2015, the disbursal of personal loans (the term RBI uses for home loans, education loans, vehicle loans, loans against shares, bonds and fixed deposits, and what we call personal loans) went up by 16.1%. This after the RBI cut the repo rate by 125 basis points during the course of the year. One basis point is one hundredth of a percentage.

How good was the personal loan growth between December 2013 and December 2014? 15.3%.

Hence, the difference in personal loan growth for the one-year period ending December 2014 and the one-year period ending 2015 is not substantial, despite lower interest rates. One explanation for this lies in the fact that banks have not passed on the entire benefit of the repo rate cut to the end consumers.

The other reason lies in the fact that not everybody is looking to borrow. Those looking to save are hurt by lower interest rates and end up consuming lesser in order to meet their target saving. And this is a point that doesn't get discussed enough, given that it isn't so obvious.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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7 Responses to "Do Lower Interest Rates Revive Consumption? Not Always"

V Thiruvalluvan

Feb 11, 2016

I am in total agreement with you. After reading the EASY MONEY books, I am able to see clearly that the requests of the so called industrialists are in line with those of the USA. The only solace is that our governments are, till today, not outright supporters of them as US govt (degree/ extent / depth), at least in the open arena.
yes, our RBI governor is correct. Now we have to save the capitalism from the capitalists. It seems, like the EQM advice of keeping calm in rising market, if the communists keep calm, capitalists will dig their own grave more quickly.


Rajagopal Ramanathan

Feb 11, 2016

An observation from my side: with some disinflation within the economy, the real cost for a borrower retail or otherwise has jumped. Any rational person in this position will rush to reduce his indebtedness than pushing up leverage. So can you kindly advice the real estate agents to smell the coffee & price their products more reasonably.


T T Krishnan

Feb 11, 2016

Business men and industrialists are only concerned with reducing their interest outgo and making more profits. They have no concern for the rest of the country especially pensioners and fixed income people for whom every fall in interest rates means having to cut corners. It is hoped your point of view reaches the powers that be more especially the Finance Minister and Prime Minister who have been pressurizing the RBI Governor to reduce interest rates. He did oblige with a big rate cut that does not seem to have made much of difference in giving the economy a boost as was being touted about.


Laxminarasimhulu Garlapati

Feb 11, 2016

Garlapati this is 100% true that the financial policy formulators keep in mind. The cii that repesent poweful business lobbies in their own interest try to push what benefits their business. Forget larger interest of nation


R K Nagpal

Feb 11, 2016

Dear Mr Geetambaer Anand : President half percent reduction will make less impact on buying property or boosting real estate industry . Buyers have lost total faith & trust in majority of the developers due to lack of transparency, in ordinate delays in delivery even after collecting 95 % to 100 % of the cost (Under construction link plan & under subvention scheme ) & the not giving the quality /specifications at the time of booking. Many of them are virtually running PONZI SCHEME & virtually cheating even the msot educated . Kindly visit National Consumer Grievances Forum INAthe maximum complaints are against builders ,UNITECH, Parasvanath, DLF and many more . heard even case is files against India Bulls for one of their at Dwarka Express all mostly on delay issues . ricky



Feb 11, 2016

The politicians want quick,phony economic growth and GDP growth, not structurally and fundamentally strong growth. They will be happy if the deposit rate becomes ZERO. Earlier Chidambaram and now Jaitly have done nothing but to copy and paste Alan Greenspan economic model. Corporates and big borrowers will be happy if the lending rate is very low so that they can borrow more and increase their profit margin. The middle class and the poor who save in Banks,
pension,PF and insurance are the losers. Already the Government is taxing the returns in most of the fixed income instruments to dissuade people from saving. Besides that, service tax is being levied on life/health insurance and pension products. If one invests 10 lacs in an immediate pension plan he has to pay a whopping 36250/!!! as service tax initially which is half of the yearly pension. The idea is simple- make savings unattractive by reducing interest rate and by imposing taxes which the politicians presume will increase spending and in turn spur economic growth.



Feb 11, 2016

I hope central bankers across the world are reading this simple column and realize how dangerous it is to just keep slashing interest rates hoping that the consumption will pick up and economies will revive :-)

Thank you so much Vivek for this wonderful and simple write-up.

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